Markets nervous as Fed’s focus starts to shift to balance sheet

Any hint that the Fed is turning its attention to reducing the size of its swollen balance sheet could roil markets.

Traders working on the Mizuho Americas trading floor in New York earlier this year. (AP Photo/Mark Lennihan)

Whenever the US Federal Reserve Board’s open market committee meets there’s enormous anticipation over what it might say about the likely future course of US interest rates. After this week’s meeting, there will be more than one reason for Fed watchers to pore over the detail of the Fed’s deliberations.

There is no expectation that the Fed will follow up December’s 25 basis point increase in US short-term rates with another rate rise, even though the members of the committee have foreshadowed three more 25 basis points rate hikes this year.

Apart from some soft recent economic data, in these early tumultuous days of the Trump administration the Fed is likely to err on the side of caution, waiting to see how the campaign promises — which are at face value highly stimulatory — translate into actual policy.

There has been a flurry of excitement among those who follow the Fed closely in recent weeks, however, sparked by comments from regional Fed presidents about the prospect of a decision by the US central bank to signal the eventual start of the unwinding of a balance sheet swollen by the unconventional measures it adopted in response to the financial crisis.

Before the crisis, the Fed had a balance sheet of just under $US900 billion. Today, as a result of its bond and mortgage purchases via its quantitative easing programs, its balance sheet has expanded to about $US4.5 trillion.

Since 2014, when the QE programs ended, the balance sheet has been unchanged, with the Fed reinvesting the proceeds from maturing bonds and mortgages to avoid withdrawing liquidity from the US economy.

The Fed has made it clear, with the US economy expanding at a reasonable rate, unemployment low and the inflation rate edging up even before the stimulus of the Trump tax cuts, infrastructure spending and deregulation are factored in, that it will continue to tighten US monetary policy until rates are “normalised”.

It has also indicated that, apart from keeping inflation under control, it wants to re-create the capacity and flexibility to respond to any future downturn or stresses in the US economy by loosening monetary policy.

At the moment it has limited headroom in either the rate structure or its balance sheet to manoeuvre.

It can normalise monetary policy by pulling on either or both of the two main levers it has. One is by raising rates; the other is through the way it manages its balance sheet.

An increase in US official rates directly impacts short-term rates. The Fed balance sheet has the potential to influence longer-term rates. Both have the potential to withdraw liquidity and tighten monetary policy in the US, which would spill over from bond markets into currency and equity markets and have global implications.

While there is no expectation of an immediate shift in the Fed’s balance sheet strategies, even the hint that a reduction in its size is envisaged within the medium term has the potential to roil markets.

In 2013, when then Fed chair Ben Bernanke suggested the Fed might start scaling back the size of its bond purchases later that year there was the famous “taper tantrum”, with a massive sell-off of bonds, a consequently sharp spike in yields, a big dip in equity markets and significantly volatility in currency markets. It’s a sensitive topic.

The Fed’s current chair, Janet Yellen, said late last year that the Fed would start to allow the portfolio to run off (by not reinvesting the funds released by maturing securities) once the process of normalising US rates was well underway.

Philadelphia’s Federal President, Patrick Harker, said earlier this month that the Fed should consider ending reinvestment once the federal funds rate reached one per cent. The Fed’s current target rate range for the federal funds rate is 0.5 per cent to 0.75 per cent. If it’s foreshadowed three rate rises were to occur, the rate would clearly be above one per cent by the end of 2017.

Yellen has said that halting the reinvestment program would be equivalent to two 25 basis point rate rises. She has said that the impact of the Fed’s balance sheet on longer term rates was diminishing, which she described as “passive tightening” of monetary policy. A decision to begin shrinking the Fed’s balance sheet would, therefore, be a policy of more active tightening.

Part of the explanation for the sudden bout of interest in the Fed’s balance sheet is that if the Fed were to rely on simply raising short-term rates to limit the likelihood of a future inflation breakout it would likely lead to a further strengthening of a US dollar which has already appreciated quite sharply and could rise further if the Trump administration’s “America First” pro-growth, deficit-funded initiatives are implemented.

That would ultimately undermine America’s competitiveness and growth rate. It could also trigger crises in emerging market economies overexposed to US dollar-denominated borrowings and generate global instability and potentially another bout of financial crisis.

There is a view among economists and analysts that fluctuations in short-term rates are the major influence in the value of the dollar, while a sell-off in longer-dated bonds and consequent increases in long-term rates has less of an impact on the currency.

That supports an argument for the Fed to slow the rate of increases it plans in official rates while bringing forward the point at which it starts shrinking its balance sheet by ceasing to invest the cash from maturing securities.

How it might manage a shift from the current focus on rates towards a more balanced strategy of withdrawing liquidity would be important if it is to avoid a re-run of the taper tantrum.

Philadelphia’s Harker is only one of a number of regional Fed presidents who believe the Fed should at least start discussing the prospect of a change to its balance sheet strategy.

Yellen’s predecessor, Bernanke, however, has argued that there is no urgency about starting to process of unwinding the program and significant risk of disruption to markets and the US economy in starting the process before the US rate structure is closer to being normalised. He would also like there to be a debate about the optimal size of the Fed’s balance sheet, saying that might not be radically smaller than it is today.

Whether the Fed does do something to begin reducing the size of its balance sheet this year, or more likely next year, it will inevitably try to provide some guidance to the market well ahead of the change to avoid the risk of another market tantrum.

The Fed’s dive into the uncharted waters of unconventional monetary policy and quantitative easing in response to the financial crisis — and the continuing maintenance of large-scale bond and mortgage purchase by the European Union and Japan, along with negative policy rates — has created distortions in financial market settings and investor behaviours and has been a contributor to rising wealth inequality in developed economies and the political instabilities of the post-crisis period.

Ideally, US policy, and indeed that in Europe and Japan, would be normalised and central banks retreat to the background of economy policymaking rather than, as they have been post-crisis, the primary drivers of it.

Unwinding the massive legacies of their responses to the crisis, more than eight years later, isn’t going to be an easy or riskless process, nor one quickly effected.

Given the volatile and unpredictable nature of the new US administration, the degree of difficulty for the Fed in trying to normalise US monetary policies without adversely impacting the economy in future — and without blowing up financial markets in the process — is going to be doubly difficult.